Don’t waste your time with a zero interest rate loan

Do-it-yourself super funds, and the experts that advise on them, who have been asking the Australian Taxation Office for clarity on the issue of whether fund members could not only lend their fund’s money to make investments but do so on terms more favourable than financial institutions like banks have finally got an answer.

It’s a response that will justify the growing discomfort that a number of advisers have felt about the strategy.

With a message meant to be related to DIY funds that have become increasingly excited about the concept, leading super advisers were informed by the ATO via a liaison group meeting held through a national telephone link-up late last week, that it didn’t approve of overly friendly investment loans between members and super funds. In particular, so-called related party loans to buy property or shares at concessional – even zero – interest rates were given the thumbs down by the ATO.

This message was passed on by advising the experts, and through them their clients, that no private rulings would in future be issued by the ATO that allowed funds to borrow from members on terms dramatically more favourable than could be organised through a formal lender.

Funds are also set to be warned that if they go ahead with the low or nil interest-related loan strategy in a belief it is possible, they are likely to face a 45 per cent penalty tax on the income the investments generated, such as the rent from an investment property, under what are known as non-arm’s length income rules.

The ATO advice was prompted by a steady stream of applications lately from DIY funds for private rulings that seek approval for the strategy. This flow followed recent suggestions that have been circulating in DIY super circles that anyone wanting to implement the strategy should not act before getting an ATO ruling.

Trustees should expect knocking back

As a result of this, says Adelaide super specialist Suzanne Mackenzie of DMAW Lawyers, there have been about 20 applications for private rulings that focus on low or nil interest-related party loans with many more believed to be in the pipeline. However, the latest response from the ATO, says Mackenzie, is that trustees of DIY funds are wasting their time and the $2000 to $3000 it could cost them in expert adviser fees to apply for a private ruling they hope will allow them to implement the strategy.

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All the recent applications for related loans with low or zero interest rates will be knocked back and anyone seeking a private ruling to implement a similar strategy will face the same outcome. Furthermore they risk that penalty tax on the investment income will be imposed regardless of whether a fund has moved into pension phase, a time when super fund investment income might normally be regarded as tax-exempt.

Another prominent super tax adviser, Daniel Butler of DBA Lawyers, says what should be clear for anyone considering applying for a ruling that will allow them to lend money to their super fund at a concessional interest rate is that they will be knocked back. While they can apply for a ruling they shouldn’t expect a positive response.

Butler’s advice for anyone who may have already implemented a personal loan to their super fund on friendly terms is to revisit this and revise it so the terms are no more favourable than a loan obtained from a financial institution on commercial terms.

Since late 2007, DIY super fund trustees have been able to borrow to make investments on the condition that any loan is organised under a limited recourse arrangement, meaning that if there is any risk of the investment failing, a lender can only target the investment bought with the loan, a property for instance.

The complexity and cost that can be involved in such arrangements has led to an alternative strategy being promoted where members with the financial resources have sought to save themselves money by personally lending this to their fund to buy investments and pay themselves the loan interest. This strategy, known as a related party loan, has generally been regarded as acceptable so long as the loan terms are organised on an arm’s length basis, meaning they are very similar to terms between a fund and a commercial lender. This would suggest a loan with a similar interest rate, security requirements and amount lent – the loan to property ratio – as a commercial lender would require. The major difference should be the loan interest being paid by the fund to a related party which could be a family trust.

Confusion arises from past comments

This particular strategy has been complicated by suggestions from some advisers that it could be possible for related loans to be made on more favourable terms.

Why some may think this is possible is due to confusion about this strategy in the past, including comments from the ATO that it wouldn’t regard any benefits a fund received from a nil interest loan as tax concessional contributions liable to the 15 per cent contributions tax. Some advisers interpreted this as giving approval to a low or nil interest-related party strategy. There have also been private rulings where some ATO comments have been read as allowing concessional arrangements.

Butler says that at last week’s discussion about related party loans, industry participants asked the ATO for clarity on related party loans generally. While many experts think that if the terms replicate commercial arrangements they should be acceptable, some formal guidance would be welcome.

This leaves the options for a DIY fund considering a related party loan, says Butler, to either implementing an arm’s length arrangement in a structured way by going to several banks or commercial lenders, comparing the terms of their loans and then replicating this in a related party loan. Or wait for the ATO to publicly clarify its position after the dust from the current debate has settled. One thing a fund wouldn’t do in the current environment is implement a concessional interest or concessional terms strategy such as a 100 per cent loan on a very low or zero interest rate.

As far as future guidance from the ATO is concerned, says Butler, it’d be preferable if it had a solid legal basis rather than interpretations that appear to stretch the law. If the law needs changing, this should be done.